Put Some Longshots in Your Portfolio

 | Oct 16, 2013 | 2:00 PM EDT
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I have frequently in the past confessed a strong attraction for longshot stocks. I like these stocks that are ridiculously out of favor and struggling to execute a turnaround.

Most of my efforts are focused on safe and cheap stocks with the potential for high returns, but I confess to having a few longshots around most of the time. I have advised my son and daughter that they should have an even higher percentage of these stocks in their portfolio than their old man does as the math is just too compelling.

Consider a portfolio of carefully-selected longshots with the potential to triple in price over the next three to five years. If you are right about 40% of your selections and just average breakeven on the rest of the bundle, you end up handily beating the markets historical returns. If it takes three years, you end up averaging 21% and if stretched out to five you still have a compound annual return a little over 12%.

A 30% win rate gives you a return of between 8% and 14%, depending on the time it takes to play out. With the application of a hardy dose of common sense and a strong stomach for volatility, the 40% win rate should not be difficult to achieve. It is the same mindset that makes private equity and distressed investing so successful.

If you look at the stocks I identified as longshots in the second half of 2011 and all of 2012, there were 25 names on the list. Twenty-two of the stocks are higher, although admittedly with a boost from a strong stock market. The biggest loser is my old nemesis, Hampton Roads Bankshares (HMPR), with a nice loss of almost 80%. The biggest winner is Cemex (CX) with a tidy 200% return already.

More importantly taken as a group,  the package of stock is up more than 80% over just an 18 -month time frame. I have not graded out 2013's longshots yet, but we have already seen some big winners in stocks like Cumulus Media (CMLS) and Cowen Group (COWN) that were longshot portfolio suggestions.

One way I search for long shots is to set aside some of my traditional metrics. I simply look for companies with higher leverage that I normally accept that also have high Piotroski F scores, which indicates improving fundamentals. I then cut that list down to companies that have tumbled into single digits, and have a long way to climb if management is successful in turning the business around.

Skilled Healthcare Group (SKH) operates skilled nursing facilities, assisted living facilities, hospices, home health provider and a rehabilitation therapy business. This used to be a $14 stock, but it now fetches less than $5. The stock was over $7 back in July, but missed analyst forecasts for earnings and revenue and investors dumped the stock aggressively. The debt-to-equity ratio is a daunting 400%, but the company does have an F-score of 7. This indicates fundamental improvements are taking place that have not been recognized by Wall Street just yet. At the first sign of good news, this stock could begin a climb back in the direction of the old highs.

Alaska Communications Group Company (ALSK) provides integrated communications services to consumer and business customers in and out of Alaska. The company's wire line and wireless communications networks extend throughout Alaska. The company recently announced new broadband capabilities for businesses that should help drive future growth. The new service will be rolled out shortly in the Anchorage area and introduced to the rest of the state over the next few years.

Five years ago, this stock traded for more than $10 a share and just halfway back to that level would be a huge return. They carry a high debt load with a debt to equity ratio of 500%. But the F-score is an impressive 8, indicating better times ahead for the company, and hopefully the stock.

Not all longshots work out. It has been my experience, however, that if you use a little common sense and look for decent companies simply dealing with a rough patch, more longshots than you might think work out nicely.

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